“If you’ve never diversified your portfolio beyond stocks and bonds, you should know about the powerful argument for managed futures,” the bank wrote. “Managed futures may potentially profit at times when traditional markets are experiencing losses.”
Morgan Stanley presented a chart telling investors that over 23 years, people who put 10 percent of their assets in managed futures outperformed those whose investments were limited to stocks and bonds.
Clients jumped in. During the decade that ended in 2012, more than 30,000 investors entrusted Morgan Stanley with $797 million in a managed-futures fund called Morgan Stanley Smith Barney Spectrum Technical LP.
Top fund managers invested that cash in a range of asset classes. In that period, the fund made $490.3 million in trading gains and money-market interest income.
Investors who kept their money in Spectrum Technical for that decade, however, reaped none of those returns — not one penny. Every bit of those profits — and more — was consumed by $498.7 million in commissions, expenses and fees paid to fund managers and Morgan Stanley.
After all of that was deducted, investors lost $8.3 million over 10 years. Had those Morgan Stanley investors placed their money in a low-fee index mutual fund, such as Vanguard’s 500 Index Fund, they would have reaped a net cumulative return of 96 percent in the same period.
The “powerful argument” for managed futures turned out to be good for brokers and fund managers but not so good for investors.
In the $337 billion managed-futures market, return-robbing fees such as those are common. According to data filed with the Securities and Exchange Commission, 89 percent of the $11.51 billion of gains during that decade in 63 managed-futures funds went to fees, commissions and expenses.
The funds held $13.65 billion of investor money at the end of last year, according to SEC filings. Twenty-nine of those funds left investors with losses.
The $8.3 million loss in Morgan Stanley’s Spectrum Technical fund over a decade pales in comparison to an aggregate deficit of $1 billion in 29 Morgan Stanley and Citigroup managed-futures funds in the four years that ended Dec. 31, the filings show. Those funds charged investors a total of $1.5 billion in fees. Morgan Stanley and Citigroup merged their funds’ management in 2009; Morgan Stanley bought out Citi’s share in June.
“The big news here is, the fees are so outlandish, they can actually wipe out all the profits,” says Bart Chilton, one of five members of the Commodity Futures Trading Commission. Even though the CFTC oversees managed futures, Chilton says he hadn’t been aware of the effects of the high costs for investors.
“We absolutely need to do a better job of letting consumers know in plain English what’s going on,” he says. “Those numbers tell a story. It’s astounding.”
Morgan Stanley’s chief investment strategist, David Darst, who has written a book on managed futures, declined to comment on his firm’s fees. Bank spokeswoman Christine Jockle also declined to comment on the funds.
“Fees associated with managed-futures funds across the industry have been historically high,” Jockle says.
Brokers have an incentive to keep clients in managed-futures funds because they receive commissions annually of up to 4 percent of assets invested, prospectuses show. Investors pay as much as 9 percent in total fees each year, including charges by general partners and fund managers.
People put money into managed futures because their brokers recommend them, says Thomas Schneeweis, a finance professor at the University of Massachusetts at Amherst who was a futures-fund manager from 2004 to 2010.
“Everything is marketing,” he says. “Getting out there and pushing it. These things are sold, not bought.”
Broker pitches that don’t clearly tell investors about the drastic effect of fees should be considered fraudulent, says James Cox, a securities law professor at Duke University.
“Otherwise, the pitch is a half-truth,” he says. The government is to blame for allowing these products to be offered with inadequate disclosure, Cox says. “I would call it a license to steal,” he says.
Because the managed-futures market is opaque and poorly understood, otherwise-sophisticated investors often don’t realize how pervasive the profit-eating fees are. The firms marketing the funds are at times also left in the dark. The industry refers to the computers programmed with trading algorithms as black boxes.
Some banks say they can’t see into the boxes of the traders they hired.
“Particularly given the black box character of many managed-futures strategies, it is virtually impossible for the manager to detect strategy changes,” Bank of America’s Merrill Lynch said in an August 2010 SEC registration for its Systematic Momentum FuturesAccess.
The 7,752 investors in that fund faced losses of $135.3 million, after fees, from 2009 to 2012, according to Merrill’s SEC filings. Merrill spokesman Bill Haldin declined to comment.
When financial advisers promote managed-futures funds, they often rely on charts produced by a small company in Fairfield, Iowa, called BarclayHedge. The firm, which has no connection to London-based Barclays, reports a 29-fold gain through 2012 for managed futures overall since 1980. Those numbers can mislead investors.
BarclayHedge doesn’t deduct billions of dollars of fees charged by funds. It uses only information volunteered by managed-futures traders. Traders can stop providing data if their system starts to lose money or collapses, says BarclayHedge President Sol Waksman.
The BarclayHedge data, even with their flaws, Waksman says, are the industry benchmark. Investors need to look at more than just his index, he says.
“They’ve got to accept some of the blame for going into something without any knowledge,” he says.
Managed-futures funds are a subset of hedge funds. They’re run by commodity-trading advisers, or CTAs, who these days invest largely in financial futures. While hedge funds typically charge a 2 percent management fee and 20 percent of investor profits each year, a managed-futures fund often duns clients 7 to 9 percent of assets invested annually and 20 percent of any profits.
The National Futures Association, a self-regulatory group, doesn’t require managers to disclose the effects of fees on investor profits over time, says Mary McHenry, an associate director in its compliance department.
“We can’t just give investors all the answers,” she says. “It’s important that they ask questions before they invest.”
While brokers commonly promote managed futures as protection against stock market declines, the language in prospectuses belies that notion. Managed futures are non-correlated; that means their performance doesn’t track that of any other investments, positively or negatively.
“As a risk transfer activity, trading in commodity interests has no inherent correlation with any other investment,” Grant Park Futures Fund, which is marketed by UBS, wrote in its February prospectus. In other words, managed futures behave like a knuckleball in baseball.
Players know a knuckleball isn’t a fastball or a curveball, but beyond that, they don’t know what it will do. A managed-futures fund isn’t a stock or a bond; it may sometimes behave like one — and sometimes not.
McHenry says she knows that brokers pitch managed futures as protection from stock market declines — and that fund risk disclosures say there’s no correlation. Asked how those contradictory statements add up, she says, “I don’t know how to answer that question.”
Like hedge funds, managed-futures funds haven’t been required to file with the SEC as a matter of course. However, an SEC rule has mandated that any partnership with more than 500 investors and $10 million in assets — even a hedge fund — must file quarterly and annual reports.
The SEC has no category listing managed-futures funds, as it does for mutual funds or corporate filings. Bloomberg Markets culled through thousands of filings in several categories, including one called “SIC 6221 Unknown,” to identify 63 managed-futures funds that reported to the SEC.
While each trading adviser has a different black box, there are similarities in how fund managers approach their jobs. Some of their investments are plain vanilla. They place money from investors into U.S. Treasury bills or other short-term debt. They then use about 15 percent of the funds to buy or sell futures contracts.They can bet that prices will rise or fall on more than 150 futures contracts, including those covering stock indexes, government bonds, currencies, interest rates, agricultural commodities, oil and metals.
Treasury bills turn out to be critical. Interest income from T-bills and other debt investments has effectively masked the high fees funds charge their investors. The 63 funds that reported to the SEC collected interest totaling $2.34 billion in the decade from 2003 to 2012.
Without those gains, the combined 10-year earnings of $1.3 billion after fees in the 63 funds would have been converted to a loss of more than $900 million. As interest rates have fallen to historic lows since 2008, managed-futures funds have suffered their largest declines ever.
Fund managers amp up the risk in their investments by using leverage. They can buy futures contracts on margin, with down payments as low as 10 percent. A $100 investment in Morgan Stanley’s Spectrum Technical fund, for example, bought $1,000 worth of futures contracts, according to its 2003 prospectus.
By comparison, the New York Stock Exchange requires investors to maintain a minimum margin of 25 percent of the market value of a purchased security.
Even the managed-futures funds that file with the SEC don’t have any obligation to disclose how fees in recent years ate up all trading gains.
One of the biggest and oldest futures managers, Baltimore-based Campbell & Co., did well for investors in the 1990s and early 2000s. Its flagship Strategic Allocation Fund provided a 10.5 percent compounded annual rate of return to investors in its first decade of trading through Dec. 31, 2003.
What followed wasn’t as good. From 2003 to 2012, more than 15,000 investors put a total of $4.5 billion into the fund. Clients were recruited by Merrill Lynch, UBS and other firms. The Strategic Allocation Fund earned $2.43 billion, according to SEC filings.
Those returns shrank to $158.8 million after investors paid fees and expenses of $2.27 billion, equaling 93 percent of the gains. The result was a 0.6 percent compounded annual rate of return for the decade. That compares with 7.1 percent, including dividends, for the S&P 500 during the same period. Campbell closed the fund to new investors in 2008.
As with most managed-futures funds, Campbell develops algorithms for its black box. Those systems are flawed, Campbell tells investors in annual reports.
“A previously highly successful model often becomes outdated and inaccurate, sometimes without Campbell & Co. recognizing that fact before substantial losses are incurred,” the firm wrote. Keith Campbell, founder and chairman of the firm, declined to comment.
The knuckleball nature of managed futures can flummox even the professionals. Gerald Corcoran, chief executive of Chicago-based R.J. O’Brien & Associates, the nation’s largest independent futures broker, says he recently lost money investing in managed futures. Corcoran, 58, is a director of the Futures Industry Association.
His $25 million RJO Global Trust managed-futures partnership, pitched to retail investors with as little as $5,000 to invest, fell 35 percent during the four years that ended Dec. 31 after gaining 41 percent in 2008. It charges up to 7.25 percent in annual fees.
“You’re going to lose money in managed futures over the course of a period of time. There’s no question,” Corcoran says. “I mean, I’ve just experienced it myself.”
“I actually would not even encourage most retail investors to be in managed futures,” Corcoran continues. “It’s on the riskier end of the investment spectrum.” He says managed futures serve wealthy investors. “They’re an important part of a diversification of a sophisticated portfolio,” he says.
Best and worst
The 220,000 Morgan Stanley clients that bought the 13 funds started by the firm and are included in SEC filings paid a total of $2 billion in fees, commissions and expenses during the decade that ended Dec. 31. (The bank opened four of those funds after 2003.)
Investors lost money in seven of the 13 funds, SEC filings show. Spectrum Technical performed well during its first eight years, starting in November 1994. Its investors received a compounded annual return of 7.9 percent in that period. In the decade that ended Dec. 31, 2012, the fund had no gain. Morgan Stanley closed the fund to new investors in 2008.
The worst of the 13 funds was the Managed Futures Premier BHM Fund, which was started in November 2010. It had a compounded annual return of negative 11.7 percent over two years and two months. Five of the six gainers had compounded annual returns below 1 percent.
The best performer, the Morgan Stanley Smith Barney Spectrum Strategic Fund, had a compounded annual return of 2.1 percent during the decade that ended Dec. 31. By comparison, the Fidelity Money Market Fund gained a compounded annual return of 2.9 percent in the same period.
Darst, Morgan Stanley’s chief investment strategist, cautions investors about the cost of managed futures in his book, “Portfolio Investment Opportunities in Managed Futures.”
Darst says investors shouldn’t pay more than 2 to 3 percent in annual fees for managed-futures funds. He says that’s steep compared with other investments.
“That’s something you’ve got to be upfront with people about,” he says. “This is not a bargain-basement kind of thing.”
Jockle, the Morgan Stanley spokeswoman, says the firm’s managed-futures funds performed well during the stock market plunges that began in 2000 and late 2007. The funds overall gained 22.5 percent after fees in 2008. The bank sells only to investors it deems qualified, and it clearly defines risks and fees, she says.
Morgan Stanley is lowering fees for its new funds, she says.
So incomplete are the disclosures for managed-futures funds that investors, referred to as limited partners, sometimes can’t even find out the names of the people managing them. BlackRock, the world’s biggest money manager, refused to name the CTAs it hired for the BlackRock Global Horizons I partnership, even after the SEC requested that information in 2009.
“We do not believe that disclosure of the trading adviser identities would be material to limited partners,” BlackRock wrote to the agency.
The SEC persisted.
“Because your trading advisers manage your assets, it appears that the identity of these persons is material,” the SEC wrote back.
Five weeks later, BlackRock began making the disclosures. The fund lost $10.2 million for investors in the decade that ended Dec. 31, after paying fees, commissions and expenses of $170.3 million.
In the secretive world of managed futures, managers often keep millions of dollars of investment gains even as their clients suffer losses. And hype by brokers routinely gives investors misimpressions.
One improvement for investors would be a mandate that managers clearly explain in writing how severely fees have consumed returns over time.
“We don’t have a requirement where they have to present that information,” says McHenry, of the National Futures Association. “That would be valuable.”
The full version of this Bloomberg Markets article appears in the magazine’s November issue.